Problems and Questions – Risk Measurement and Hurdle Rates in Practice

Rem.: Use 5.5% as your equity risk premium, for T. Bonds, where none is given, and 8.5% as your short term ERP.

1. In December 1995, Boise Cascade’s stock had a beta of 0.95. The Treasury bill rate at the time was 5.8%, and the Treasury bond rate was 6.4%. a. Estimate the expected return on the stock for a short-term investor in the company. b. Estimate the expected return on the stock for a long-term investor in the company. c. Estimate the cost of equity for the company.

2. Boise Cascade had debt outstanding of $1.7 billion and a market value of equity of $1.5 billion; the corporate marginal tax rate was 36%. a. Assuming that the current beta of 0.95 for the stock is a reasonable one, estimate the unlevered beta for the company. b. How much of the risk in the company can be attributed to business risk and how much to financial leverage risk?

3. The following table summarizes the percentage changes in operating income, percentage changes in revenue, and betas for four pharmaceutical firms.

...
Over the Hurdle
Executive Summary
Currently, Teletech Corp. is using a single corporate hurdlerate to evaluate its investment decisions in its products and systems segment as well as its telecommunications segment. Using only one hurdlerate doesn’t take into account the risk that the company faces within each segment. Investors demand higher returns for riskier investments. Victor Yossarian is concerned about the low returns for the high risk in the products and systems segment, this is why he wants to abandon this segment. Using two hurdlerates adjusts for the risk in each industry allows the company to adequately value each segment. Our analysis will show that by using two hurdlerates it will lower the cost of equity and WACC for the less risky telecommunications segment, while raising the cost of equity and WACC for the more risky products and systems segment. Lastly, our calculation of the economic profitability for each industry using the segmented hurdlerates will show that Teletech may be overvaluing its products and systems segment while undervaluing its telecommunications segment. This implies that Teletech should reallocate its capital in order to increase economic profitability .
Introduction
We will conduct an industry comparison analysis...

...Problem 6-10a
Given the holding-period returns shown here, compute the average returns and the standard deviations for the Zemin Corporation and for the market.
MONTH ZEMIN CORP. MARKET
1 6% 4%
2 3 2
3 -1 1
4 -3 -2
5 5 2
6 0 2
Zemin Corp Mean = 6 + 3 + -1 + -3 + 5 + 0 = 10/6 = 1.6
Market Mean = 4 +2 +1 + -2 + 2 + 2 = 9/6 = 1.5
Zemin Corp Standard Deviation
6 -1.6 ^ = 19.36
3 -1.6 ^ = 1.96
-1 -1.6 ^ = 5.2
-3 – 1.6 ^ =9.2
5 -1.6 ^ = 11.56
47.28/5 = √9.45=3.56
Market Deviation
4 - 1.5 ^ = 6.25
2 – 1.5 ^= 0.25
1 – 1.5 ^ = 0.55
-2 – 1.5 ^ = 7
2 -1.5 ^ = 0.25
14.3/5 = √2.86= 1.97
Problem 6-10b
If Zemin’s beta is 1.54 and the risk-free rate is 8 percent, what would be an appropriate required return for an investor owning Zemin? (Note: Because the returns of Zemin
Corporation are based on monthly data, you will need to annualize the returns to make them compatible with the risk-free rate. For simplicity, you can convert from monthly to yearly returns by multiplying the...

... The company’s main problem is believed to lie in the financial planning processes and in the risk consideration. To tackle these problems the assistant to the firm’s vice president suggests a target capital structure of 45% debt in every division and differing hurdle rated for low, average, and high risk projects.
This paper critically reviews the different suggested measures and finally proposes measures that should be taken to improve the performance of the Randolph Corporation.
Divisional HurdleRates
To estimate the hurdlerates for every division of the Randolph Corporation that weighted average cost of capital (WACC) have to be calculated for every division. To apply the formula of the WACC the costs of equity have to be known. The cost of equity can be determined through the Capital Asset Pricing Model (CAPM). The results for every division’s equity cost and the computation of the hurdlerates can be seen in the Appendix. The divisions with higher risk have higher weighted average cost of capital.
WACC/HurdleRate
Real Estate 9.19%
Ceramic Coatings 10.24%
Equipment Manufacturing 10.55%
Home Products 9.34%
Fig. 1: Hurdlerate per division
To account for different levels of risks between the company’s projects the...

...1. During the past five years, you owned two stocks that had the following annual rates of return.
Year Stock T Stock B
1 0.19 0.08
2 0.08 0.03
3 -0.12 -0.09
4 -0.03 0.02
5 0.15 0.04
a) Compute the arithmetic mean annual rate of return for each stock. Which stock is most desirable by this measure? (5 marks)
b) Compute the standard deviation of the annual rate of return for each stock. By this measure, which is the preferable stock? (7 marks)
c) Compute the coefficient of variation for each stock. By this relative measure of risk, which stock is preferable? (3 marks)
d) Compute the geometric mean rate of return for each stock. Discuss the difference between the
arithmetic mean return and the geometric mean return for each stock. Relate the differences in the mean returns to the standard deviation of the return for each stock. (5 marks)
2. a)What is meant by separability theorem? How does this contradict the “interior decorator” school of
thought? (10 marks)
b) An investor is evaluating six portfolio with the following characteristics:
Portfolio Portfolio Expected Portfolio Standard
Return (%) Deviation (%)...

...Finance 3303 Business Finance Chapter 11 PracticeProblems
1. Two investment opportunities have the following expected cash flows. If your minimum required return is 27%, which proposal would be the best based on the Net Present Value evaluation method?
Investment A Investment B
Year 0 $( 567,000) $( 577,000)
Year 1 $ 254,000 $ 256,000
Year 2 $ 287,000 $ 281,000
Year 3 $ 260,000 $ 290,000
Year 4 $ 155,000 $ 145,000
A) Neither proposal would add value.
B) Choose Proposal A because it has the highest IRR.
C) Choose Proposal A because it has the highest NPV.
D) Choose Proposal B because it has the highest IRR.
E) Choose Proposal B because it has the highest NPV.
Answer: A [NPV for A: $(2,548); NPV for B: $(3,892)]
2. You’re evaluating a proposed business project and you want to know what is the Internal Rate of Return. Based on the following estimated Free Cash Flows and the IRR method, would this project be accepted? Your required return is 16%.
Year 0 1 2 3 4
Cash Flow $(963,500) $420,899 $510,000 $312,200 $144,000
A) No, because the IRR is less than 16%, it’s 18.94%.
B) Yes, because the NPV is $57,900.
C) No, because the IRR is lower than 16%, it’s 11.98%
D) Yes, because the IRR is higher than 16%, it’s 19.46%
E) No, because the IRR is less than 16%, it’s 5.09%.
Answer: D [IRR = 19.46% and NPV =...

...Frequently Asked Questions
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Assignment 9
The due date for this quiz is Mon 16 Sep 2013 6:30 PM IST (UTC +0530).
Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including $, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100.
In accordance with the Coursera Honor Code, I (Shravan Vepa) certify that the answers here are my own work. Thank you!
Question 1
(5 points) In a world with no frictions (i.e., taxes, etc.), having debt is always better because it increases the value of the firm/project.
False.
True.
Question 2
(5 points) The return on equity is equal to the return on assets of a project/firm.
Always true.
Never true.
Sometimes true.
Question 3
(10 points) Moogle, Inc. is in the same business as Google, Inc., but has recently retired all its debt to become an all-equity firm. Its return on equity has dropped from 12.25% to 10.60% as a result of this. Google, Inc. continues to have debt in its capital structure, and its debt-to-equity...

...THE DIRECT D E T E R M I N A T I O N of RISK-ADJUSTED DISCOUNT RATES and LIABILITY BETA
RUSSELL E. BINGHAM T H E H A R T F O R D FINANCIAL SERVICES G R O U P
Table of Contents
Page 2 3 5 7 8 11 12 13 14 14 15 16 17 17
18
Subject Abstract 1. Summary 2. Total Return Model 3. After-Tax Discounting 4. Derivation of Risk-Adjusted Discount Rate and Liability Beta Figure l : Baseline Risk / Return Line vs Leverage 5. Liability Beta Figure 2: Equity vs Liability Beta Figure 3: Equity Beta vs Risk-Adjusted Discount Rate (After-Tax) 6. Underwriting Profit Margin Figure 4: Underwriting Profit Margin vs Loss Payout Figure 5: Underwriting Profit Margin vs Investment Yield Figure 6: Underwriting Profit Margin vs Market Risk Premium Figure 7: Underwriting Profit Margin vs Leverage 7. Conclusion Related Background Reference Reading Appendix - Example Exhibit I - Balance Sheet, Income, Cash Flow and Rates of Return Exhibit II - Net Present Value Without Risk Adjustment Exhibit I I I - Net Present Value With Risk Adjustment Exhibit IV - Myers-Cohn "Fair" Premium With After-Tax Discounting
19 20 23 24 25 27
Abstract
The development of a complete financial structure including balance sheet, income and cash flow statements, coupled with conventional accounting and economic valuation rules, provides the foundation from...

...Question 1
( 5 points) In a world with no frictions (taxes, etc.), value is created by how you finance a project.
True.
False.
Question 2
(5) The return of equity is equal to the return on debt of a project/firm
Always true.
Never true.
Sometimes true.
Question 3
(10 points) Moogle, Inc. is in the same business as Google, Inc., but has recently retired all its debt to become an all-equity firm. Its return on equity has dropped from 12.25% to 10.60% as a result of this. Google, Inc. continues to have debt in its capital structure, and its debt-to-equity ratio is 30%. What is the return on assets of Google, Inc.(No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 3
Question 4
(10 points) Suppose CAPM holds, and the beta of the equity of your company is 2.00. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 4.5% and the risk-free rate is 3.00%. Suppose the debt-to-equity ratio of your company is 20% and the market believes that the beta of your debt is 0.20. What is return on assets of your business? (No more than two decimals in the percentage interest rate, but do not enter the % sign.)
Answer for Question 4
Question 5
(10 points) You are...

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